Are UK shares undervalued?

The single biggest challenge in comparing one stock market with another is that no two stock markets are alike. The oil & gas sector, for example, makes up 7.8% of the FTSE 100, but less than 1.9% of the American S&P 500. If the oil price is low, and oil & gas stocks are out of favour, this will affect the UK stock market more than it’s US counterpart.

That can make it difficult to tell whether one market is truly ‘better value’ than another.

However, the size and diversity of the UK stock market means it has lots of businesses that are British only in name. These companies generate much, even most, of their profit from sales overseas. Unlike a UK high street retailer, their competitors are spread all over the world. And all things being equal, you’d expect them to have a similar valuation to those international peers.

With that in mind, we’ve picked three of the largest sectors in the UK stock market with clear international equivalents – Oil & Gas, Consumer Goods and Tobacco. We’ve looked at how those businesses are valued compared to their international equivalents.

Tobacco

The tobacco industry is dominated by the so called ‘Big Four’– British American Tobacco, Imperial Brands, Japan Tobacco International and Philip Morris International. Of those four companies two are UK listed, British American Tobacco and Imperial Brands.

In some ways, these are perfect indicators of how people feel about the ‘UK stock market’. All four sell a relatively generic product and investors only have four options to pick from.

The graph below shows that while all companies in the sector have seen their Price to Earnings (PE) ratios sink, the two UK companies have struggled. PE ratios measure how much investors are prepared to pay for a company relative to the profits it generates. While investors have gone off all tobacco stocks to some extent, they’re even less interested in those tobacco companies listed in London.

PE Ratio of the world's four largest tobacco companies

Source: Refinitiv Datastream, 09/11/20.

Now there are lots of reasons why the valuations for Imperial Brands and British Tobacco might have fallen – after all, all companies are unique with unique advantages and disadvantages. Perhaps Japan Tobacco and Philip Morris are just better companies than their UK counterparts – and there are plenty of investors who believe that’s the case.

To say that UK companies are being structurally undervalued compared to international peers we need to look for more evidence.

Fast Moving Consumer Goods

Fast Moving Consumer Goods is a broad sector, and technically includes Tobacco companies. However, if we look specifically at companies manufacturing food and household products, we again find UK listed companies have underperformed their international peers in terms of valuation.

Change in PE ratio of consumer goods groups Q4 2015 - Q4 2020

Source: Refinitiv Datastream, 09/11/20

We should flag that direct comparison between these businesses is a bit of a challenge. Some are in food, some are in household cleaning or personal hygiene products, and some are a combination of both. However, across the broad bracket of peers we looked at, including those in the table above, the UK listed groups struggled more than others.

In fact, PE ratios for Unilever and Reckitt Benckiser (UK listed) have fallen by around 20% over five years, while many rivals have seen their ratings increase substantially.

Oil & Gas

As we said earlier, Oil & Gas shares make up a large portion of the UK stock market, mostly through Royal Dutch Shell and BP.

These two companies have seen their share prices plunge over the last year as lower oil prices wrecked first revenues and then profits. That’s been bad news for the UK stock market as a whole.

Although, the thing about oil prices is that they’re global, and oil prices are low for everyone at the same time. If global oil prices have hurt Shell and BP, then they should’ve also hurt Exxon Mobile and Total. However, once again we find that UK shares are at the bottom of the pile when you look at valuations.

Price to Book ratio of Global Oil Majors

Source: Refinitiv Datastream, 09/11/20

In this case we’ve looked at Price to Book rather than Price to Earnings. A price-to-book ratio shows how much a company is worth on the stock market compared to the value of all the assets it owns. It’s useful for looking at asset heavy businesses which might be making a loss instead of a profit (that’s been true for lots of oil companies in recent times).

On this measure, UK oil & gas majors have long been unpopular. BP and Shell were bottom of the pile five years ago and they remain bottom today. However, apart from Exxon Mobile, which was trading on a fairly astonishing valuation five years ago, the valuations of BP and Shell have also fallen harder than those of rivals.

BP’s Price to Book ratio is 64.8% lower than five years ago, and Royal Dutch Shell's valuation was 46.0% lower.

So, what does this all mean?

Firstly, we can’t stress enough that the mere fact that a company has a low PE ratio doesn’t mean it’s ‘cheap’. Poor companies trade on lower valuation’s than exceptional companies, just as new, good quality cars cost more than second-hand bangers.

Any one of the companies listed above could turn out to be even more of a banger than the share price implies. Ratios only tell part of the story and shouldn’t be looked at in isolation.

However, the fact the largest UK companies seem to be systematically trading on lower valuations does seem to suggest the UK stock market is somewhat neglected. At a market level, international investors are steering clear, and that has the potential to create pockets of opportunity.

Upcoming decisions about Brexit could continue to put investors off the UK. That means we could see UK companies remain undervalued for some time. However, over the longer term, investing at lower valuations has tended to deliver better returns for investors. Remember though, this isn’t guaranteed.

This article isn’t personal advice. If you’re at all unsure then please ask for advice.

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The Author holds shares in Imperial Brands Group

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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